Mind The "GAAP" (Or How The Game Is Really 'Rigged')

Those that have worked on wall street know that a financial analyst's life can generally be summarized as a never-ending quest for pro-forma, adjusted, non-GAAP EBITDA, or what the Wall Street Journal calls “earnings before bad stuff." Turns out, to our complete "surprise", that minding the "GAAP" (see what we did there) is probably a better idea. A study by the Wall Street Journal of companies in the S&P 1500 found that companies that rely most heavily on earnings adjustments are more likely to encounter accounting problems than companies that just focus on GAAP earnings. Per the WSJ:

The study focused on companies in the S&P 1500 index. It found that just 3.8% of those exclusively using standard GAAP metrics had formal earnings restatements from 2011 to 2015. Among heavy users of non-GAAP measures—those whose non-GAAP earnings were at least twice as high as their GAAP net income—the rate was 6.5%.

Similarly, 7.5% of the GAAP-only group had material weaknesses in internal controls—flaws in their procedures to prevent financial errors and fraud—versus 11% of the non-GAAP group.

To be clear, the WSJ doesn't think that all addbacks are bad, per se, just when they're used to "manage market expectations.

For instance, companies using non-GAAP income measures to exclude employee stock compensation may be the kind of younger outfits that encounter troubles with accounting systems because they are expanding rapidly, said Patricia Dechow, a University of California at Berkeley accounting professor.

But non-GAAP use could also signify a company is concerned with managing market expectations and “may be more likely to push the line on GAAP earnings,” Ms. Dechow said.

Yes, because adding back stock compensation is so innocent in the absence of other accounting issues. After all, stock compensation isn't "real" compensation just like depreciation isn't a "real" cost either...no one ever actually repairs or replaces old buildings and equipment, right? As we previously pointed out in a post entitled "Mind The Non-GAAP: Real S&P Earnings Are The Lowest Since 2010," Warrent Buffett summarized the issue best in a quarterly letter to shareholders:

... it has become common for managers to tell their owners to ignore certain expense items that are all too real. “Stock-based compensation” is the most egregious example. The very name says it all: “compensation.” If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?

Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring “earnings” figures fed them by managements. Maybe the offending analysts don’t know any better. Or maybe they fear losing “access” to management. Or maybe they are cynical, telling themselves that since everyone else is playing the game, why shouldn’t they go along with it. Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors.... When CEOs or investment bankers tout pre-depreciation figures such as EBITDA as a valuation guide, watch their noses lengthen while they speak.

While we agree with Warren, the problem is that the issue goes much deeper. Even within the confines of "GAAP" reporting, CFO's have a number of levers that can be pulled to "manage" earnings. Aggressive accrual policies, while they might technically be GAAP-compliant, make it pretty easy to move expenses from the P&L to the balance sheet...and the best part of all is that when accruals get too bloated then they can be expensed in a 1x charge that wall street conveniently adds back as "extraordinary." The bottom line is that the game is rigged and if you're going to play it then you better be well trained at finding the shenanigans.